light at the end of the tunnel

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From Dan Denning at the Old Hat Factory:

--It will be important not to zag when you can zig in the coming months. Or zig, when you can zag, if you prefer. But what do we read in the paper today? Investors are being told to do just the opposite of what they ought to be doing! Imagine that.

--"Analysts rate Westpac a buy," says Andrew Carswell in today's Daily Telegraph. The bank told investors on Friday that it expected profit for the financial year to rise between six and eight percent. Let's call it seven. But wait. It gets better.

--Analysts at UBS raised the price target on the stock to $25, which is about thirty-one cents below where it trades today. Bold! Merrill Lynch says Westpac has the lowest risk, highest quality assets in the Aussie banking sector. It rates the shares a buy too. Zig.

--But why not zag?

--Is it not obvious by now-one year into the credit crisis-that banking is a terrible business when you strip away the fancy suits and big ties? It is subject to massive blowups and failures. When run prudently, of course, this does not happen. Banks are discrete in their loan-making, maintain adequate capital, and pay investors a dividend for their risk.

--For banks to deliver faster earnings growth, they have to take more lending risks. This leads, especially at the tail end of a manic credit boom, directly to the situation you most want to avoid, banks that lower lending standards to grow the portfolio. It also leads, inevitably, higher rates of default.

--Why on earth would anyone want to own a business that is structurally exposed to black swan events that destroy shareholder capital? Anyone? Beuller?

--The 'zag' strategy would be to forget shares altogether until the banking crisis is sorted out globally, in which case you'd be primarily in cash. Or, you could buy shares of companies that are less prone to negative black swans but equally (if not more so) beaten down. Here we have companies like Worley Parsons (ASX:WOR) in mind.

--Worley reported a 53% rise in full year profit today. It's Australia's best engineering firm. It's got business in four different booms: energy, infrastructure, mining, and power. It has clients all over the planet. And as far as beaten down value, it's down 33% year- to-date.

--We don't mind telling you it was one of our "set and forget" tips in Diggers and Drillers before we handed the investment reins of that publication over to Al "Smokey" Robinson. But here's what we'd say for the moment: the beat down in the resource market is going to give you the best chance since 2003 to buy a portfolio of world-class projects at very good values. More on that below.

--But hey, if the analysts say buy the banks...who are we to disagree?

--Did you see the great interview with Vancouver-based mining magnate Robert Friedland in today's Financial Review? It's worth three dollars to read the interview (how's that for inflation?).

--Friedland is talking up the Aussie float of Ivanhoe Australia Limited (ASX:IVA). He is a world class promoter and, depending on your perspective a visionary the likes of Andrew Forrest.

--His strategy is simple. Buy a distressed asset. Front up the money to drill it like nobody's business. Demonstrate that it's worth a lot more than you paid for it. Then find a JV partner to front up the rest of the capital to make it a producer.

--Friedland is also a big fan of "polymetallic mineralisation," a kind of selling Peter's gold to pay for Paul's copper production. When you have a world-class polymetallic deposit, you can use the cash-flow generated from one metal to sustain, or at least off-set the production costs, in another.

--Friedland thinks he's got a goer at Mount Isa. "The Mount Isa mining district is one of the top five mineralised districts on planet earth," he told the Fin. "It doesn't have to apologise to anyone. There's the Witwatersrand in South Africa, there's Norilsk in Russia, there's the Cadillac district fault in Canada, there's the main structure in Chile. This is one of the great mining regions in the world."

--He may be right. Yet IVA's shares are selling nearly 18% below the float price of $2 per share. Even polymetallic assets get quashed when you have a bear market in base metals and a one-day decline of four percent in the gold price to US$825.

--Yet the man is probably on to something. And he points out that these great new ore bodies of the mining world (charity calendar coming out soon) will replace many tired, old, bed-ridden mines at the end of their productive life. "Our view, and we talk to Rio about this a lot, is around the year 2012 or 2013 we are going to have a crisis in copper because a lot of the great copper mines are like little old ladies lying in bed waiting to die."

--Younger mines will have plenty of cost blow outs (see Ravensthorpe). They will have to endure volatility in underlying commodity prices. But they have one thing the older mines don't: a lot of ore in the ground. That's worth something, especially at today's shares prices.

--Is the Red Bear Rising again? We promised a few extra thoughts on what's going on the Caucasus yesterday. Here they are. Investors should take note that Russia's Grand Geopolitical Strategy is resource based (energy and metals). This leads us to at least three insights, which could, of course, be wrong. But here they are anyway.

--The balance of power in the world has shifted to resource producers (because of relative scarcity) and not consumers. You see a mini version of this in China (an iron ore and coal consumer) and its steadfast objection to a Rio-BHP merger (Aussie resource producers). The merger, from China's perspective, would create the so-called OPEC of Iron ore. If pricing power shifts to the producers, so does a greater share of the profits. Profit margins on Chinese steel would go down and the cost of steel-essential to China's great industrialisation-would go up.

--Second, we see that in the execution of this strategy--a resurgent Russia asserting itself against former Soviet territories and controlling all the energy corridors to Europe from Siberia and the Caucasus-you have a potential floor in energy prices. This will scare the heat and daylight out of natural gas consumers in Europe. But it also puts a premium on non-Russian energy projects, which investors might want to consider owning. Hello North West Shelf.

--Finally, symbolically (along with the hosting of the Olympics by an authoritarian capitalist State) this indicates the end of benign globalisation and the beginning of a bull market in State on State warfare over resources. It will be a much darker, competitive period of economic history. Not quite a New Dark Ages. But that would be the worst-case scenario.

--The good news in all of this? You can do something about it! The resource sector has been pounded so much recently that world-class projects (like the ones Friedland is talking about) are selling at pretty significant discounts.

--Put simply, this is the best time to be a buyer of resource stocks since 2003. By the end of the year, a smart investor could end up with a buy-and-hold ten-year portfolio of the best resource and energy firms in the world. It's an opportunity that probably won't come again for quite some time.